Schwab Earnings Preview: The Quiet Giant Will Benefit From A Bull Market
Summary
- Over time, Schwab should be able to return more capital to shareholders.
- "Chuck" is the low-cost discount broker leading the way with lower commissions.
- The "money-market fee waiver" benefit has now dissipated as fed funds rise.
- Schwab could start returning excess capital to shareholders.
- Schwab is still mildly diluting shareholders - I wish they'd stop doing that.
Charles Schwab (NYSE:SCHW) is the market share and cost leader in the old "discount broker" market. I think that sector title has lost its cachet - Schwab, Ameritrade (AMTD), Interactive Brokers, etc. have now become more "asset gatherers" and individual-investor enablers for a full panoply of investment management and investment planning services. The EF Hutton's, Merrill Lynch's and Smith Barney's of the 1970s to 1990s have now morphed into the Schwabs and TD Ameritrades of the millennial generation.
Briefing.com couldn't confirm the earnings date and for some reason Schwab is always somewhat suspect about their date, but Briefing.com does expect Schwab to report their Q2 '17 financial results on July 18th, 2017.
Analyst consensus per Thomson Reuters I/B/E/S is expecting $0.39 in earnings per share on $2.1 billion in revenue for expected year-over-year growth of 30% and 16% respectively - not too shabby if you ask me.
A Quick Look at the Numbers:
| Q2 '17 est | Q1 '17 | Q4 '16 | Q3 '16 | |
| 2019 EPS est | $2.20 | $2.26 | $2.30 | $1.95 |
| 2018 EPS est | $1.95 | $1.95 | $1.99 | $1.72 |
| 2017 EPS est | $1.63 | $1.62 | $1.63 | $1.52 |
| 2019 EPS est gro rt | 13% | 16% | 16% | 13% |
| 2018 EPS est gro rt | 20% | 20% | 22% | 13% |
| 2017 EPS est gro rt | 24% | 24% | 24% | 19% |
| 2019 P.E | 19(x) | 17(x) | 18(x) | 16(x) |
| 2018 P.E | 22(x) | 19(x) | 21(x) | 19(x) |
| 2017 P.E | 26(x) | 23(x) | 25(x) | 21(x) |
| 2019 rev est (bl's's $'s) | $10.7 | $10.9 | $10.9 | $9.7 |
| 2018 rev est | $9.7 | $9.7 | $9.7 | $9.1 |
| 2017 rev est | $8.7 | $8.6 | $8.6 | $8.3 |
| 2019 est rev gro rt | 10% | 13% | 11% | 7% |
| 2018 est rev gro rt | 12% | 13% | 13% | 10% |
| 2017 est rev gro rt | 16% | 15% | 15% | 12% |
Source: Internal spreadsheet with Thomson Reuters I/B/E/S estimates as of July 14th, 2017
Readers can see how the earnings and revenue numbers started to trend higher as Q3 '16, the market rally post-Brexit and post the Presidential election in November '16, and then when the price/commission war started with Fidelity in Q1 '17, the numbers came down.
Schwab, considered by Morningstar to be the "cost leader" among the traditional discount brokers, was taken by surprise earlier this year when Fidelity came out lowered their trading commission to $6.95 (I believe) and Schwab matched it immediately. Within a week, Schwab lowered the trading commission again to $4.95, which Fidelity matched.
The war between Fidelity and Schwab started years ago and still continues to the substantial benefit of advisors, investors and traders.
The History
For full and fair disclosure to readers, as an investment advisor, Schwab is my 3rd party custodian, a service they began to offer in the late 1980's, and which is now a substantial part of their business.
In my opinion, the collapse of the technology bubble in the early 2000's was Schwab's "2008" so to speak, and really set the company (as well as Schwab competitors) on a safer path to balance sheet and capital management. That really helped when 2007-2008 struck.
ETrade (ETFC) had a tough time after the early 2000's due to their mortgage business and was forced to do a 1-for-10 reverse split in 2010 (similar to many large banks). In the early 2000's after the collapse of the tech bubble, Schwab put a renewed emphasis on asset-gathering, and during the 2000-2002 collapse of individual trading speculation, reduced some of their branch overhead. Here in Chicago, Schwab closed some branches, and relocated some others to higher floors in prime retail locations, which I thought was a prudent move.
TDAmeritrade is probably Schwab's closest direct competitor, but Schwab has the lead in "asset-gathering" with over $3 trillion in assets under management. TD Ameritrade has lagged Chuck in the asset-gathering department, with roughly $1 trillion in AUM.
Today, the Schwabs and the Ameritrades in my opinion have replaced the Merrills and the Lehmans and the Smith Barneys of your parent's generation. The discount brokers have become the lower-cost, full service providers to those interested in the stock and bond markets.
Schwab and the other discount brokers are lower-risk business in my opinion today since - to my knowledge - none of these firms do proprietary trading with firm capital. As such, firm revenue is derived from lower-risk execution, custody and asset management fees.
To be an advisor today, with lower compliance and custody risk, is easy since RIAs can custody assets with a Schwab or Ameritrade or an Interactive Broker, and the RIAs then bring assets to the respective custodian.
The Future:
Anyone who was around in the 1980's or 1990's remembers how the brokerage usually acted in bull markets, and for Schwab and Ameritrade and such this time should be no different. The market sentiment gauges today still indicate a healthy degree of skepticism and fear. Given the overvalued nature of the bond market, there still seems to be a lot of cash that is still not invested today.
Beginning in the spring 2013, U.S. investors entered a new secular bull equity market, as SP 500 earnings have risen from roughly the $110 area in 2013, to an expected $131 - $132 "per share" level for 2017.
For Emerging Market investors, the 10-year downtrend ended in January - February 2016, and for European large-cap investors, the 10-year bear market just ended this year (or is in the process of ending). I do think Schwab eventually eliminated all trading commissions and possibly takes extra basis points on money market and traditional '40 Act funds.
The money market fee waiver, which was a significant headwind for Charles Schwab, has all but ended for Schwab. Here is the trend in the "fees waived" by Schwab on the money market funds in the last 6 quarters:
| Qtr | Fees waived (ml's $'s) | EPS cost TTM | MMkt assets $(bl's $'s) |
| 3/17 | $8 | $0.10 | $163 |
| 4/16 | $31 | $0.17 | $163 |
| 3/16 | $41 | $0.26 | $162 |
| 2/16 | $55 | $0.35 | $161 |
| 1/16 | $97 | $0.44 | $166 |
| 4/15 | $153 | $0.51 | $161 |
Source: Schwab earnings reports, 10-Qs and Street research
With the Fed/FOMC having fully committed to eliminating ZIRP (zero interest rate policy) the previously waived fees have now returned as part of Schwab's revenue stream, possibly for good. Seeking Alpha readers have been kept updated on this aspects of Schwab's earnings since late 2013 (here and here). It was a long wait to get rid of ZIRP and now it's over.
Technical Analysis
Technical Software: Worden 2000
In May 1999, Schwab hit an all-time-high of $51.99 (according to the software) and then again in April 2000, Schwab hit a high of $44.78. As you can tell from how Schwab trades today, the stock has been consolidating in the low $40s and might take some time to trade above these all-time-highs.
Readers don't have to try and predict the action, just wait until the $45 level is taken out on above average volume, and then we should quickly see $51 - $52 in short order.
Valuation
| 3-yr avg exp EPS gro rt | 19% |
| 3-yr avg P.E | 22(x) |
| 3-yr avg exp rev gro rt | 13% |
| ROE | 13% |
| ROE (tangible) | 14% |
| ROA | 0.99% - 1% |
| Div yield | 0.07% (less than 1%) |
| Div / share repo % of FCF | 22% |
| Free-cash-flow yield | 4% |
| Price-to-book | 3.5(x) |
| Dividend payout | 21% |
| Mstar intrinsic value | $46 |
Source: Internal spreadsheet from earnings reports, 10-Q's, Street research
Analysis/Conclusion
While we rarely discuss cash flow and free cash flow when discussing the valuation metrics of the financial sector (the discussion typically revolves around capital and/or excess/deficient capital), in my eyes Schwab and the discount brokers are a lot like the exchanges -- higher fixed-cost businesses that have a high degree of operating leverage, but their market risk comes from being market entities (custodians, risk managers, etc.) rather than proprietary traders. These are less riskier market businesses than the old investment banks, and proprietary traders that we knew in the 1900's and 1990's. The point is that Schwab currently sports a credit rating of A2/A/A (Moody's/S&P/Fitch) and short-term liquidity ratings of P-1/A-1/F-1 (highest quality short-term ratings.)
While the money market fee waiver just ended for all practical purposes, Schwab and financials as a whole should be returning to a "more normal" operating environment over the next few quarters and years. (Note Jamie Dimon's conference call comments today.)
Schwab at the end of March 31, 2017, had $2.2 bl in free cash flow on a trailing 12 months basis at the end of Q1 '17. If normal conditions should begin to prevail, Schwab will/could be in a position to return more shareholder capital over the next few years.
After holding the $0.32 dividend constant from June 2009 to June 2016 (seven whole years), Schwab has increased the dividend $0.01 per share to $0.07 from June '16 to March '17 and has increased it again to $0.08 per share for June '17 through -- well, the next year. I'm a big believer companies communicate much through their dividend policies, and Schwab is saying that more excess capital is being generated, albeit still at a slow rate.
Schwab does not have a share repurchase plan in place to my knowledge, although they did for years -- a share buyback plan that was authorized in the early 2000's. My guess is the rating agencies give Schwab the big finger wag and let them know if they executed the share repo plan it might result in a credit event.
Since June 2009, when Schwab's fully diluted share outstanding bottomed near 1,100, there has been a slow, gradual increase in diluted shares to 3/31/17's 1.35 billion outstanding -- roughly a 16.5% increase in shares. The point of all is that as Schwab's business and the capital markets "normalize," there should be an opportunity to return more capital to Schwab shareholders. (The rating agencies won't get over 2008 for a long time, so expect the ratings to stay on the conservative side for many moons.)
In terms of valuation, Schwab's current valuation is rather "garpy" (growth at a reasonable price) with an expected three-year average growth rate of 19% and a multiple of 22(x). Schwab is the leader in the old discount brokerage group nearing $3 bl in assets under management and a core "net new asset" growth rate of mid- to high single digits. Most importantly, Morningstar considers Schwab the "low-cost leader" in the discount brokerage sector, which usually results in a premium valuation over time.
There is a never-ending onslaught of market negativity in the mainstream financial media regardless of what a market is doing, so I'm partial these days to individual stocks that were leaders in the 1980's and 1990's, and have thus consolidated the last 15 - 17 years but are poised to make new all-time-highs. At the same time, they have stabilized or improved their competitive position within their sectors. (Technicians will tell you that when stocks break out of a 15-, 17-year base, the stock can run higher for years.)
Schwab fits that description, and if readers think that as an advisor that custodies assets at Schwab that I gain any particular benefit from these articles, let me add that relative to most Schwab advisors my assets under management are likely small, and I get no benefit from these articles. (In fact, I'm sure there has been a few times where my support team and senior management would have strangled me if they could.)
Charles Schwab started the first discount brokerage in the mid-1970's after commissions were deregulated. The firm hasn't stopped innovating, not to mention the fact that he and the senior management team have avoided any leadership fiasco that could have damaged the substantial Schwab brand.
Stay long "Chuck" and use pullbacks to acquire shares assuming the fundamentals haven't changed. Schwab could be to this young millennial generation what Merrill Lynch was to the 1970's - 1990's.
Disclaimer: Schwab is my custodian as RIA.
This article was written by
Analyst’s Disclosure: I am/we are long SCHW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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